New Wave ETFs: People, Planet & Profits

March 01, 2017

[This article originally appeared in our March issue of the ETF Report.]

Sustainable investing has its own lingo, with terms like "socially responsible," "values-based," "environmental, social and governance (ESG)" and "impact." Without knowing the definitions, it can be hard to wade through what the different terms mean and how each type of investing reaches its goals.

The good news is they're all related in some way, even if there are different permutations. 

Jon Hale, director of sustainable investing at Morningstar, says while investors can make some distinctions in the different types, what it ultimately comes down to is that these funds are choosing companies based on an evaluation of their environment, social or corporate governance performance—not just financial profitability.

'Holistic Assessment'
"It's making some sort of holistic assessment of companies on that dimension in addition to the financial dimension," he added.

Although sustainable investing has its roots going back decades, for a long time, many financial advisors likely shied away from it at least in part because of a 2008 Department of Labor bulletin that frowned on using these themes to invest.

That changed in late 2015, when the agency granted permission for fiduciaries to use ESG factors when making investment decisions, says Tom Kuh, executive director of ESG Indexes at MSCI.

That ruling may assuage financial advisors' concern about looking at the space, and increases in the amount of data available from companies and third-party providers is allowing product providers to offer new investment vehicles.

Below is an explanation of the different types of sustainable investing styles and their different goals.

Socially Responsible Investing
This is an umbrella term that dates back to some of the earliest sustainable investing. It includes values-based or faith-based investing, such as funds for Catholics or Islamic-law-based funds. One of the hallmarks is screening out companies based on moral views—usually alcohol, weapons and tobacco.

The first socially responsible investments (SRI) used these exclusionary screening approaches, and they still exist to a certain extent, such as funds that screen out fossil fuels, Hale notes. It's these negative screening approaches that led some investors to think SRI has a drag on performance. Overall research shows that sustainable investing doesn't adversely affect return, but depending on the makeup of the fund, screens can at times fall out of favor.

"There's a theory around SRI investing that you're going to sacrifice performance. And if you're depending on primarily negative-screening products, like fossil fuels—think about the energy space. It's bound by the cycles of oil, cut and dried. If oil goes up, you lose; if oil is down, these products are winning," said Bob Jenkins, head of Lipper and fund research at Thomson Reuters.

With this type of values-based investing, the goal is not necessarily return.

"The nature of applying the screen on fossil fuels or Catholic institutions not owning pharma companies, the nature of those screens is they're done without reference to the potential financial implication of applying the screen," MSCI's Kuh said.

Christine Chardonnens, executive director at MSCI Index Product, says some of these products take a more sophisticated "best-in-class" approach toward screening to minimize drag from the negative screen. This approach selects the best-rated companies across sectors while screening out the worst of the companies involved in the negative business activity.


Environment, Social, Governance
Morningstar's Hale notes that ESG ratings take an industrywide look at companies and evaluate how each company is doing on environmental, social and corporate governance issues within its industry.

The environmental rating looks at what the most significant material environmental issues are that a company has to deal with in its particular industry.

On the social side, it mainly considers how a company treats workers, supply chain oversight, general product safety and other topics.

Corporate governance looks at how a company is governed, focusing on issues like executive compensation, separation between president and chief executive officer, and board diversity.

Hale says it's possible to mix ESG factors and use the abovementioned SRI exclusionary screening. Usually the focus with ESG is to take a more holistic approach and use positive screening that's rewarding companies for making strides in their industry.

ESG funds can also have some themes like water or alternative energy, and having the ESG criteria can help with factoring in companies developing sustainable products, he says.

These criteria are also tangible to investors. For instance, an investor might be interested in a fund containing Tesla because it's on the cutting edge of electric cars and battery technology. However, when looking holistically at the company, it may have ESG issues, because developing batteries uses a number of caustic chemicals.

The big difference in goals with ESG versus SRI is that ESG is driven by financial performance, Kuh notes.

"The idea is that you can incorporate ESG into your investment process and improve financial outcomes by enhancing long-term returns or reducing risk. What we've seen is there is a good deal of evidence in the academic and practitioner iterations that integration approaches don't hurt performance; rather, they tend to improve them. What that does for institutions is it opens them up. It addresses concerns investors might have about performance," he explained.

Impact Investing
Impact investing is still emerging, but it started as an idea that some investors want to have a high social or environmental conviction with their investment in addition to strong financial return. Sometimes in this type of investing there's a term called "triple bottom line," which focuses on people, planet and profit, and tries to give each equal footing when it comes to business operations.

This can include companies that are making sustainable products, and positive screens can include companies that are striving toward all goals, Hale notes.

Not only is the impact category younger, it reflects this new trend of a company aiming to be profitable and do well for society or the environment.

"Things in this category may generate substantial revenues from activities, that, for example, align with the United Nations' sustainability goals," Chardonnens said.



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